The Need For Skin In The Game

One of the most powerful ideas to emerge out of the post-crisis reviews of the global financial system is the need for tradeable derivatives such as credit default swaps to incorporate in future an “insurable interest”, to make sure that we never again allow hedge funds and other short term traders to take free shots at their targets (today Greece, yesterday banks and mortgages) without having any “skin in the game”.

The point was well made in an article in the Financial Times by the former general counsel of Long Term Capital Management on Friday – an insight made all the more convincing by the fact that LTCM was itself a hedge fund whose over-geared trading almost brought the financial system to a crashing halt in 1998 before being rescued (nothing like a sinner who repents to talk sense!).

Here is an extract:

Wall Street loves a piñata party – singling out a company or country, making it the piñata, grabbing their sticks and banging it until it breaks. As in the child’s game, the piñata is left in shreds. Unlike the child’s game, in the Wall Street version the piñata is stuffed with money for the bankers to scoop up with both hands, instead of sweets. We see this game being played today, with Greece as the piñata.

Investors trying to understand why their portfolios have begun to melt down for the second time in five years are becoming experts in the fiscal policy of Greece. A look at the piñata party might make things clearer.

Greece’s travails are often measured by reference to the market in credit default swaps (CDS), a kind of insurance against default by Greece. As with any insurance, greater risks entail higher prices to buy the protection. But what happens if the price of insurance is no longer anchored to the underlying risk?

When we look behind CDS prices, we don’t see an objective measure of the public finances of Greece, but something very different. Sellers are typically pension funds looking to earn an "insurance" premium and buyers are often hedge funds looking to make a quick turn. In the middle you have Goldman Sachs or another large bank booking a fat spread.

Now the piñata party begins. Banks grab their sticks and start pounding thinly traded Greek bonds and pushing out the spread between Greek and the benchmark German CDS price. Step two is a call on the pension funds to put up more margin, or security, as the price has moved in favour of the buyer. The margin money is shovelled to the hedge funds, which enjoy the cash and paper profits and the 20 per cent performance fees that follow. How convenient when this happens in December in time for the annual accounts, as was recently the case. This dynamic of pushing out spreads and calling in margin is the same one that played out at Long-Term Capital Management in 1998 and AIG in 2008 and it is happening again, this time in Europe.

Eventually the money flow will be reversed, when a bail-out is announced, but in the meantime pension funds earn premium, banks earn spreads, hedge funds earn fees and everyone’s a winner – except the hapless hedge fund investors, who suffer the fees on fleeting performance, and the unfortunate inhabitants of the piñata. What does any of this have to do with Greece? Very little. It is not much more than a floating craps game in an alley off Wall Street.

This is where the idea of CDS as insurance breaks down. For over 250 years, insurance markets have required buyers to have an insurable interest; another name for skin in the game. Your neighbour cannot buy insurance on your house because they have no insurable interest in it. Such insurance is considered unhealthy because it would cause the neighbour to want your house to burn down – and maybe even light the match.

When the CDS market started in the 1990s the whiz-kid inventors neglected the concept of insurable interest. Anyone could bet on anything, creating a perverse wish for the failure of companies and countries by those holding side bets but having no interest in the underlying bonds or enterprises. We have given Wall Street huge incentives to burn down your house.

Comment: Mr Rickards goes on to make clear that he is not disputing that public finance in Greece is a mess, which it clearly is. The folly of allowing countries into the eurozone when they deliberately falsify statistics in order to meet the entry requirements is becoming all too apparent. Unlike the Irish, who have responded to the debt crisis with commendable determination, it is difficult to have much faith in the ability of the Greeks to put their own house in order.

Mr Rickards’  point is not that Greek fiscal extravagance does not need fixing, but that it should be dealt with in an orderly fashion by governments without the incendiary assistance of footloose traders. The argument against this line of thinking is that governments only get round to solving problems when it is too late and the damage has already been done (think of the UK and the Exchange Rate Mechanism in 1992). Even if you accept this argument, however, it is clear that financial market discipline would be more responsibly exercised if it was firmly rooted in an ownership interest.